China ETFs: Factors To Consider

Published on by Jared Cummans on August 17, 2011 | Updated July 18, 2012

Interest in accessing the Chinese stock market has surged in recent years—and with good reason. China is home to one of the world’s biggest and fastest-growing economies; it is difficult to challenge the notion that China is one of the most important components of the global economy.

Not surprisingly, ETFs have become extremely popular as a means of establishing exposure to Chinese equity markets; the combination of this asset class with the cost efficiency and impressive liquidity of the exchange-traded structure results in an appealing proposition to investors.

There are approximately two dozen ETFs offering exposure to the Chinese economy, and each features a unique risk/return profile; some are most effective as trading vehicles or short term tactical plays, while others are designed for longer-term, buy-and-hold portfolios. The following sections outline the important factors to consider when browsing the roster of China ETFs, providing a guide to determine which fund is most consistent with your investment objectives.

Depth Of Holdings

This consideration is applicable to analysis of any group of ETFs, but is particularly important when considering the options available for accessing Chinese stocks. ETFs are popular in part because the offer instant diversification; through the purchase of a single ticker, investors can access dozens or hundreds of stocks. But some China ETFs are more balanced and diversified than others; at the shallow end of the spectrum are ETFs with only a couple dozen holdings, while others have more than 300 individual components. As the table in the following section shows, depth of holdings varies dramatically among the various China ETF options.

Type Of Securities

It should be no surprise that China’s stock market is unique in many ways from the U.S. exchanges. Many Chinese securities are not available to international investors; the securities held by most ETFs, including the ultra-popular FXI, are listed on stock exchanges in Hong Kong (not mainland China).

There are several different types of Chinese stocks, including:

A-Shares: These securities are traded on the Shanghai and Shenzhen Stock Exchanges in renminbi, the currency of mainland China (sometimes referred to as the “yuan”). Historically, the Chinese government had placed restrictions on A-Shares in an effort to regulate the movement of capital into and out of the country, but these restrictions have eased in recent years (more on this below).

B-Shares: These securities are also traded on the Shanghai and Shenzhen Exchange, but are denominated in foreign currencies besides the renminbi; in Shanghai B-Shares are traded in U.S. dollars, while in Shenzhen they are traded in Hong Kong dollars. B-Shares are available to both Chinese citizens and foreign investors.

N-Shares: This term refers to companies listed on U.S. exchanges, including the NASDAQ, New York Stock Exchange, and American Stock Exchange, but that have their main business operations in mainland China. Examples of N-Shares include China Telecom (NYSE: CHA), China National Offshore Oil Corp (NYSE: CEO), and China Precision Steel (NASDAQ: CPSL).

H-Shares / Red Chips: These securities are stocks of companies incorporated in mainland China that are traded on the Hong Kong Stock Exchange and denominated in Hong Kong dollars (it is not uncommon for companies to have shares listed on both the HKSE and one of the two major exchanges in mainland China). H-Shares often trade at a considerable discount to the related A-Shares, a result of the restrictions put in place by the Chinese government.

Some portions of the Chinese equity market are difficult to access for any investor who is not a Chinese citizen. Most ETFs, for example, won’t include A-Shares (PEK is the lone exception) but will instead hold B-Shares, N-Shares, or “Red Chips.”

That doesn’t necessarily diminish the investment experience; securities listed in New York or Hong Kong still derive their revenues from mainland China and are very much representative of the Chinese economy. But there may be limited options for accessing some smaller Chinese companies listed only on local exchanges, and the choice of security may have an impact on the risk/return profile realized.

A quick examination of the fund prospectus should tell you exactly where the underlying holdings are listed. For example, the regulatory documents for FXI indicate that “all of the securities in the underlying index currently trade on the Hong Kong Stock Exchange.”

State Ownership

Another unique aspect of Chinese stocks is the frequent presence of the Chinese government as a major shareholder in certain companies. For example, the Chinese government holds significant ownership interests in oil giant CNOOC and financial company China Construction Bank—among many others.

Historically, some government-owned companies have not been consistently operated with the best interest of shareholders in mind, creating a potential deterrent to international investors and drag on long-term stock returns. This issue has diminished somewhat in recent years, though it still warrants consideration when choosing from the China ETFs available to U.S. investors. Those looking to steer of state-owned firms would be better off focusing on smaller companies; ETFs dominated by mega cap stocks (such as FXI) are much more likely to be dominated by state-owned companies.

Sector Biases

When considering any international ETF, it is important to examine the sector allocation of the portfolio to determine whether an ETF offers balanced exposure or is tilted towards certain corners of the economy. This is particularly important when analyzing China ETFs, as many funds maintain biases towards some sectors (generally financials and energy) while overlooking some altogether.

The best example of this is FXI, which is by far the most popular China ETF. Almost half of the FXI portfolio is in financial stocks, while technology, utilities, real estate, consumer discretionary, consumer staples, and health care receive zero weighting in the index. That obviously limits the appeal to investors looking to achieve broad-based exposure to the Chinese economy, especially since some of the overlooked sectors (consumer companies in particular) may maintain the most promising long-term outlook.

While FXI is the most extreme example, it isn’t the only instance of major sector biases. Finding a well-rounded China ETF can be challenging and the presence of some of the sector-specific options can come in handy when trying to build a balanced portfolio. The Global X China Consumer ETF (CHIQ), for example, offers a way to beef up consumer exposure, while there are multiple options for technology exposure (CQQQ, CHIB).

Beyond The Mainland

Finally, some investors may wish to consider “indirect” options for gaining exposure to Chinese equities. There are a number of ETFs offering exposure to the Hong Kong stock market, including EWH and HKK. Moreover, both EWT and TWON offer exposure to the Taiwanese equity market. Honk Kong is a special administrative region (SAR) of China, while Taiwan’s political status is somewhat uncertain and subject to interpretation.

Regardless of the official classification, both Taiwan and Hong Kong have close economic ties to China, and companies headquartered in these economies conduct significant operations and derive significant sales from Chinese consumers and factories. Because Hong Kong and Taiwan are both developed markets, they offer potentially less volatility while still affording investors with access to China’s promising economy.

Additional Reading

For investors looking to learn more about the nuances of China ETFs, the following resources may be useful: